401k Changes Subject of Confusion
QUESTION: I am confused about the status of the 401k salary reduction plan. I thought the Reagan Administration had proposed doing away with the plan entirely, but a friend at work has heard that only some minor changes are being proposed. Who’s right?--Y. K. A.
ANSWER: Neither of you. The President’s proposal on 401k plans isn’t quite as drastic as you thought. But the proposed alterations are so severe, employee-benefits consultants say, that the 401k will lose most of its appeal if the President has his way.
You may be thinking of the Treasury Department’s tax overhaul recommendations issued last year. The Treasury, intimating that it regards the 401k retirement plan as a ruse for well-paid corporate executives to shelter their incomes, urged Congress to outlaw them.
But the President, whose tax reform proposal is considered the working document for the debate in Washington over whether the nation’s tax system should be overhauled, decided that the plan is worth saving--albeit in a less attractive form.
Salary reduction plans are the fastest growing type of employer-sponsored retirement savings programs. According to a recent survey by Hewitt Associates, a Chicago-based consulting firm, more than 400 of 762 employers surveyed have modified their retirement programs to include a salary reduction feature--a significant finding considering that this benefit has been around only 3 1/2 years.
Why their popularity? Under a 401k plan, so called because that is the section of the U.S. tax code that governs them, employees can save as much as $30,000 per year--or 25% of their annual salary, whichever is less--and defer paying taxes on that income until retirement. That doesn’t interfere with their right to save as much as $2,000 a year in an individual retirement account.
Another bonus is that employers usually contribute to the employees’ savings, in some cases as generously as dollar for dollar.
Moreover, the rules governing withdrawals from these funds are far less strict than those governing IRAs.
Taxpayers who can show that they need the money to buy a home, put their children through college or get through an emergency can withdraw money--or borrow against it in some cases--from a salary reduction plan without incurring the huge penalties that they would if they were forced to take the money out of their IRA. (Of course, they do have to pay ordinary income taxes on the amount withdrawn).
The President’s proposal would slash the maximum annual contribution from $30,000 to $8,000, minus any contributions to an IRA. In other words, if you contribute $2,000 to an IRA for the year 1986, you could contribute only $6,000 to your 401k plan.
It isn’t yet clear whether IRA contributions by an employee on behalf of his or her spouse would further reduce the 401k limit.
As drastic as that change seems, the average worker isn’t going to be hurt by it. Say you earn $30,000 a year and are permitted by the terms of your employer’s plan to contribute as much as 6% of your salary to a 401k. That works out to $1,800 a year, far below the $8,000 limit even if you figure a $2,000 contribution to an IRA.
What many workers may find far more troubling is the proposed restriction on withdrawals.
Basically, the Administration wants to make the distribution rules on all retirement plans uniform. Rather than liberalizing other types of retirement plans to bring them into conformity with 401k rules, it chose to propose distribution rules that will discourage early withdrawals from all types of tax-deferred retirement plans.
As proposed, anyone who withdraws money from a 401k before reaching age 59 1/2 would face a penalty of either 10% or 20% of the amount of the withdrawal except in cases of death, disability or separation from the company.
The surcharge would not be tax deductible and could not be offset by other tax deductions or credits.
If you were to withdraw money to pay for your child’s college expenses, to buy your first home or to replace discontinued unemployment benefits while you’re unemployed, you would be charged a 10% penalty--in addition to ordinary income taxes on the amount withdrawn. A steeper 20% penalty would apply if you withdrew the money for any other reason.
The proposals generally would be effective for plan-years beginning Jan. 1, 1986. Collectively bargained plans would not be affected until the expiration of the plan in existence at the end of 1985.
For young workers in particular, these limitations may prove overly restrictive. And if the plans can’t lure these younger, often lower-paid workers, they are in trouble. That’s because the law--in an attempt to assure their availability to all workers regardless of income level--bases the maximum amount a high-level executive may contribute to a 401k on the contributions of lower-paid workers.
Employers also are upset about the extra administrative headaches that the proposed changes would create. For example, they would have to find a way to keep track of what contributions their employees make to IRAs.
Debra Whitefield cannot answer mail individually but will respond in this column to financial questions of general interest. Do not telephone. Write to Money Talk, Business section, The Times, Times Mirror Square, Los Angeles 90053.